Budget Deficits, Tax Rules, and real Interest Rates

NBER Working Paper No. 1970Issued in July 1986NBER Program(s): EFGMEPE

This paper examines three sources of the fluctuations in real interest rates during the past three decades: changes in budget deficits, changes in tax rules, and changes in monetary policy. The evidence indicates that budget deficits and monetary policy have had a strong influence on the level of long-term interest rates but fails to identify

any effect of changes in corporate tax rates and investment incentives.

The analysis shows that it is projected future budget deficits rather than the current level of the actual or structural deficit that influence long-term interest rates. Each percentage point increase in the five-year projected ratio of budget deficits to GNP raises

the long-term government bond rate by approximately 1.2 percentage points while the ratio of the current deficit to GNP (either actual or structural) has no significa effect. The

specific parameter estimates imply that the increase in projected budget deficits was responsible for about two-thirds of the rise in the interest rates between 1977-78 and 1983-84.

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